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    INTERNATIONAL CORPORATE BANKING | INNOVATION EDGE

    Optionality and automation

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    Contributors: Gibran Maqsood & Paco De Haro

    19 Apr 2023

    In such a volatile environment, choosing the optimum hedging strategy is no mean feat. What’s more, certain derivative products, such as forwards, are becoming more costly. One way to ensure the company’s hedging approach keeps pace with rapid market shifts is to build in optionality – but this requires knowledge and skill.

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    Contributors: Gibran Maqsood & Paco De Haro

    19 Apr 2023

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    FX Watchwords for Forward-Thinking Treasurers
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    FX watchwords for forward-thinking treasurers

    As 2023 continues to unfold, treasurers must expect another volatile year for FX and commodities – and adjust their hedging strategies accordingly. It is not all doom and gloom, however. Among the ‘surprises’ there will be silver linings and also opportunities to be seized.

    Paco De Haro, Head of Southern Europe FX Sales explains: “Covid restrictions in China last year accounted for slightly over half of the dollar’s outperformance. As China reopens, and travel to the country gathers pace again, we expect to see a pick-up in demand for commodity currencies as well as emerging market FX, with appreciation expected in those currencies. Arguably, there is a sweet spot there for some calculated risk-taking, although treasurers are not typically ones to speculate.”

    De Haro cites the Chilean peso as an example.

    That said, there may be a significant downside to this higher demand for commodities – namely even higher inflation. With central banks across the globe already raising rates to combat inflation, this could be an additional concern for treasury teams. Indeed, inflation ranked as the top macroeconomic worry for treasurers in the TMI and Barclays European Treasury Survey 2022 (see fig. 1).

    Nevertheless, the intense environment has highlighted the importance of hedging, and re-evaluating hedges on a regular basis.

    But just as interest in hedging solutions is increasing, so too is their cost in certain instances. “There have been significant moves in FX forwards due to the increased cost of carry. In three- to six-month tenors, we’re looking at the cost of hedging doubling in some currency pairs. And in the nine-month to one-year tenors, we’re seeing an additional 150% increase on some of those costs.”

    While the possibility of seeing a narrowing interest rate differential between the euro and the US dollar should translate into a lower cost of hedging in time, he believes the expense is likely to remain elevated in the near-term.

    Taking positive action

    In this environment, hedging strategies require careful consideration – and, often, specialist expertise. “Volatility makes hedging even more expensive. But there are strategies corporates can use to reduce the volatility premium,” explains De Haro. “Let’s get technical for a moment. Think about a European exporter to the US market. FX collars are a common approach, and the exporter would usually look to buy a EUR call/USD put and sell a EUR put/USD call. The carry element here means that this can be difficult to formulate without taking additional risks. But by sacrificing a little bit on the strikes, and moving away from an at-the-money forward in favour of an option, there is the possibility to gain a little on the upside, and mitigate some of the potential cost if the market moves the other way.”

    There are many different strategies treasurers can explore to reap these optionality benefits. Typically, though, corporates will examine the at-the-money forward rate, and from there, determine what their comfort level is above that rate. From there, they can assign a portion of the portfolio to be hedged via optionality. “It’s a process that requires a certain level of experience, but there are some very interesting potential benefits to considering optionality, rather than simply hedging via forwards,” De Haro confirms.

    Of course, there are considerations too – after all, there is no free lunch – these include:

    • Volatility carries a premium that has to be paid, depending which side of the market you are.
    • If the market moves against you, your effective hedging rate will be higher than the at-the-money money forward. (But if the market moves in your favour, the option that you’ve sold will move in-the-money, and that will mean you get a pricing exercise at a better rate than the at-the-money forward).
    • There are almost infinite combinations of leverage barriers that can be used to increase the attractiveness of effective hedge rates. “It is important not to take on excessive leverage,” cautions De Haro. “These structures can be very painful if they work against you. And while knock-out barriers can be useful, these also come at a risk.”

    The bottom line is that successful hedging requires expertise and careful planning.

    Tech to the rescue

    Alongside fresh approaches to hedging, advances in technology are also helping treasury teams to reduce the costs associated with FX. “Automation carries enormous benefits. And in these very volatile markets, automation helps to reduce operational risk, especially at the point of execution,” notes De Haro. In turn, automation frees up resources and enables human capital to be deployed on more value-added activities.

    Gibran Maqsood, Head of Transactional FX Sales, Europe, Barclays Corporate Banking, agrees, adding that he expects increasing numbers of treasurers to begin automating their hedging strategy during these uncertain times (see fig. 2).

    This is important, says Maqsood, because regardless of policy or specific hedging instrument decisions, the ultimate effectiveness of your strategy is strongly dependent on the execution approach that you use. “And those execution channels have evolved significantly over the past 20 years or so, with sophisticated corporates proactively embracing the latest developments.”

    Maqsood describes the evolution in three phases:

    1. The pre-electronic era. Execution was primarily manual and carried out predominantly by phone, fax, or email. “Risk was aggregated, and then executed through human-centric workflows,” he explains.
    2. The electronic era. This saw the proliferation of single-bank and multi-bank electronic dealing platforms. “Corporates’ main focus here was on efficiency and accuracy. So, the speed of execution became important, alongside responsiveness, latency, and access to liquidity. Nevertheless, there was still a tendency to aggregate risk and a lot of pressure on the treasurer to tactically execute that strategy.”
    3. The automation era. Although still in its early stages, and continually evolving, automation offers the ability to capture FX at the source. “As a result, the manual work to aggregate risk and analyse it is effectively removed,” comments Maqsood.

    With this electronic evolution, there has been what Maqsood calls a “democratisation of the FX space”. There is also more awareness among corporates of the potential for technology to improve their FX workflows, he believes.

    Simplification in action

    “Imagine, for example, an e-commerce environment where an organisation is selling products or a service,” continues Maqsood. “Historically, the FX risk arising from that environment would have been managed in a very manual way. There would have been some pre-hedging based on a forecast, and a month-end adjustment process. And a pricing exercise would have been carried out in tandem to reflect any market changes within pricing.”

    Today, much of this work can be mitigated at source by using an API to plug FX rates – either live or guaranteed – into every transaction. That is then seamlessly integrated into the displayed prices on the e-commerce gateway. “So, rather than aggregating their FX risk, sellers are automatically executing live micro-FX trades, without any of the manual legwork associated with such an approach.”

    Another task where automation can add value is in treasury’s hedging cycle – in other words when the firm’s FX exposures are identified, evaluated in terms of risk, and policies and hedging plans are drawn up and then executed. “During that process, a great deal of data is typically pulled from multiple sources and there is a lot of number-crunching happening in spreadsheets or other tools. Then there is netting activity to determine the aggregate risk, and finally execution of the decided strategy.”

    All of this takes time and eats up human resources. “Today, FX providers can do all of that hard work on the corporate’s behalf. Sophisticated providers can leverage technologies such as AI and machine learning, as well as bespoke data analytics tools, to analyse the data provided by clients based on pre-set rules dictated by the client. The technology can then determine and recommend FX rates and hedging strategies based on those rules, which saves a lot of time and effort.”

    A third example where tech can add value in FX is vendor payments. Maqsood outlines: “The typical workflow here would be to look at your payment run for the next week and then fund different currency accounts on a weekly basis. Naturally, there is significant friction if an FTE is manually undertaking this work, and managing different currency accounts can be very cumbersome.” But technology now enables all of those vendor payments to be made from a single-currency account. “So, if you’re able to find a provider that can offer you transparent and competitive FX rates on their payments platform, then there is significant potential to unlock value through process simplification.”

    Weighing the benefits

    Of course, nothing comes free of charge. And there are costs associated with FX technology, although Maqsood believes that many corporates are now prepared to pay a small price for big automation benefits. Another consideration, according to De Haro, is the timeline. “Inevitably, there is a learning curve when it comes to automation. Each organisation is different and arriving at the desired results may take a little time. These are not plug-and-play solutions. Patience is required.”

    To make the most of potential efficiencies, De Haro also recommends having clear objectives for any automation project. “The clearer your objective, the easier it is to decide on the best route to take.” Another essential, in his view, is choosing a provider with expertise and experience in FX automation. “These solutions require deep knowledge and careful thinking. Treasurers can save time and avoid pitfalls by leaning on the know-how of their trusted financial providers.”

    Meanwhile, Maqsood advocates proper management of the change process associated with automation. “This ranges from securing buy-in early on from all the teams involved, including external stakeholders, to properly balancing the project’s long- and short-term objectives,” he explains. “Patience also goes a long way with this type of project, as does celebrating the small wins, not just the big milestones.”

    Indeed, Maqsood believes that a step-by-step approach is critical to making a success of FX automation, especially since it can seem like an extremely daunting task. “What’s important is starting somewhere, and getting underway with a meaningful transformation in a small area. The scope of the project can always be expanded to other areas later on. There is no need for a ‘big bang’ approach.”

    Finally, it is important not to fear progress, comments Maqsood. “As we have outlined, there are tech-driven solutions, available today – and accessible to companies of all shapes and sizes – that can help to reduce FX risks, while providing significant operational and financial benefits in the longer term. Failing to leverage these technologies is arguably a much greater risk than embracing them.”

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    About the analysts

    Gibran Maqsood

    Head of Transactional FX Sales, Europe

    Paco De Haro

    Head of Southern Europe FX Sales

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